Tax Deduction for Interest on International Financing in So-Called “Inbound” Cases Under the Growth Opportunities Act
In our article dated March 23, 2023, we explained the tax treatment of intra-group loans in both national and international contexts. We discussed the arm’s-length and market-based interest rates for cross-border loan relationships based on the borrower’s creditworthiness profile (“stand-alone principle”). This principle was modified by the Growth Opportunities Act of March 27, 2024, for specific cross-border loan relationships (inbound financing). This is because the new Growth Opportunities Act does not exclusively contain tax measures that provide economic benefits for German companies. Rather, the Growth Opportunities Act introduces a further tax restriction for German companies regarding the tax deduction of interest expenses on loans from abroad. In addition to the general principles of an appropriate financing structure in international transfer pricing and the well-known interest limitation under Section 4h of the German Income Tax Act (EStG), the restrictive new provision of Section 1(3d) of the German Foreign Tax Act (AStG) must be observed in the future for international loan relationships. This particularly affects international group financing.
Accordingly, compared to other countries, German companies are subject to separate and, above all, strict regulations regarding the tax recognition of cross-border financing terms in so-called “inbound” cases—that is, when a German borrower takes out a loan from a foreign lender. Consequently, starting with the 2024 tax assessment period, interest expenses will be only partially deductible in the determination of taxable income for German companies if the following conditions are not met. The limitation on interest deductions is applied in the usual manner through an off-balance-sheet adjustment or the addition of the recognized interest expenses.
The full interest deduction remains available for income tax purposes provided that the international inbound financing arrangements—in addition to the existing requirements of OECD transfer pricing and the German interest barrier—are deemed to be at arm’s length in substance or amount within the meaning of the new provision of the Foreign Tax Act. This arm’s-length nature in substance (Section 1(3d)(1) of the Foreign Tax Act (AStG)) requires, cumulatively, that
- the debt service arising from the financing arrangement can be met from the outset—the so-called debt sustainability test—and
- the financing is economically necessary and is used for the company's business purpose—the so-called “use of funds test.”
In terms of the amount, a loan relationship is considered to be on an arm’s-length basis (Section 1(3d)(2) of the Foreign Tax Act (AStG)) if
- the interest rate paid does not exceed the interest rate at which the company could have obtained financing from third parties based on the group rating—the so-called group financing test—or
- the rating derived from the group rating complies with the arm's-length principle.
The borrower must therefore demonstrate that it has a certain level of debt-bearing capacity and that the loan is necessary. In addition, interest rates are also accepted if they correspond to the rate at which the company could obtain financing on the capital market based on its group rating. To this end, evidence may also be provided that another rating derived from the group rating better complies with the arm’s-length principle. It is important to note that, in the latter case, a mere demonstration of plausibility is not sufficient; this requirement must be proven. A purely stand-alone rating is therefore excluded.
According to the wording of Section 1(3d), first sentence, of the AStG, only inbound transactions—that is, loans granted from abroad to Germany—are covered. It remains unclear whether the tax authorities will also apply this clarification of the arm’s-length principle to outbound financing. In principle, the new standard should also apply to outbound cases. This would mean that loans from domestic to foreign companies would become more favorable, and German companies would receive less interest when they grant loans abroad. It remains to be seen how the tax authorities will assess the legal situation, as the text of the law, as written, covers only inbound cases.
In practice, this results in a reversal of the burden of proof to the detriment of the taxpayer. You should therefore, particularly in the case of intra-group inbound financing, document your ability to service debt, among other things, at the time the financing is obtained. The specific manner and scope of this documentation, as well as the minimum requirements—such as external group ratings—imposed by the tax authorities, remain entirely unclear at this time. Clarifying guidance from the tax authorities would be extremely helpful for (group) tax practice.
You can find our previous article on corporate financing here.
